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The Unwinding of Cross-shareholding in Japan: Causes, Effects, and Implications Hideaki Miyajima (Waseda University, Harvard University, and RIETI) and Fumiaki Kuroki (NLI Research Institute) May 2006 This paper was prepared for a chapter of the book, Corporate Governance in Japan: Institutional Change and Organizational Diversity, edited by Masahiko Aoki, Gregory Jackson, and Hideaki Miyajima. Keisuke Nitta and Nao Saito helped us to construct the data on which it is based. Yurie Otsu provided us with excellent assistance. An early draft was presented at RIETI, Hitotsubashi University, the Association for Financial Studies, and Tokei-kenkyu-kai. Comments from Naoto Abe, Katsuyuki Kubo, Takeo Hoshi, Yasuhiro Yanagawa, and Kazumi Asako, and Hiroshi Osano were extremely helpful. Correspondent address: miyajima@fas.harvard.edu Abstract Considering that the ownership structure of Japanese corporations has changed dramatically in the 1990s, this paper address a series of questions related to these changes: Why is cross-shareholding, which has been in place for almost three decades, now beginning to unwind (and what are the mechanisms of the unwinding)? What explains the increasing diversity in the patterns of cross-shareholding among Japanese firms? Lastly, what are the implications of the changing ownership structure on firm performance? Using detailed and comprehensive data on ownership structure including individual cross-shareholding relationships and other variables (Tobin’s q) developed by Nissai Life Insurance Research Institute and Waseda University, we highlight the determinants of the choice between holding or selling shares for both banks and firms. We show that profitable firms with easy access to capital markets and high foreign ownership prior to the banking crisis have tended to unwind cross-shareholdings, while low-profit firms with difficulty accessing capital markets and low foreign ownership in the early 1990s have tended to keep their cross-shareholding relationships with banks. We also show that high intuitional shareholding and, somewhat surprisingly, block shareholding by corporations have positive effects on firm performance, while bank ownership has had a consistently negative effect on firm performance since the mid-1980s. We use these findings to address some policy implications and to provide some perspectives on the future of the ownership structure of Japanese firms. JEL classification ; G21; G32; K22; L25 Key words : Ownership structure; cross shareholding, main bank relationship, firm performance; Banks' Shareholding Restriction Law 1 1. Introduction The ownership structure of Japanese firms used to have the following characteristics: shares were highly dispersed, managers and foreigners owned only limited stakes in companies, and substantial blocks of shares were held by corporations and financial institutions. Cross-shareholding, or intercorporate shareholding between banks and corporations, and among corporations, was extensive, and played an in important role in distinguishing, at least until the early 1990s, Japan’s ownership structure from that of other countries. Evolving from the postwar economic reforms, Japan’s unique ownership structure had become well established by the late 1960s, mainly because top managers considered it to be effective in warding off hostile takeover threats. The remarkable stability of this ownership structure may explain why it lasted for almost three decades. Cross-shareholding has also played a key role in supporting Japanese management and growth-oriented firm behavior in the postwar period (e.g. Abegglen and Stalk 1985, Porter 1992, 1994). It encouraged the patterns of stable shareholding that have allowed managers to choose growth rates that deviated from the stock price maximization path (Odagiri 1992) and to adopt steady dividend policies that were insensitive to profit (with important implications for governance). Furthermore, the joint ownership of debt and equity by banks purportedly enhanced corporate performance by improving their monitoring of client firms and helping to mitigate asset substitution problems. The high level of ownership by non-financial institutions has also had a significant influence on the monitoring of Japanese companies (Sheard 1994, Yafeh and Yosha 2003). The ownership structure that took root during the postwar period has undergone dramatic changes over the past decade, however. Foreign investors began to increase their stakes in Japanese companies in the early 1990s, especially in larger firms. And more recently, the ratio of shares held by stable shareholders (antei kabunushi) began to plummet from previous heights. Table 1 shows the stable shareholder ratio for the period from 1987 to 2002 (estimated by NLI (Nippon Life Insurance) Research Institute; henceforth, NLIR). The stable shareholder ratio is defined as the ratio of shares held by commercial banks, insurance companies, and non-financial firms (business partners and the parent company) to total shares issued by listed firms, calculated on a value basis (market valuation on the reference date). Until the 1990s, stable shareholders were assumed to be 2 friendly insiders. The stable shareholder ratio has been declining since the mid-1990s, and the rate of decline has accelerated since 1999. The ratio was 45% in the early 1990s but plunged to only 27.1% in 2002. The last three columns of Table 1 show the shares owned by the three categories of investors categorized as stable shareholders banks, insurance companies, and non-financial firms. While cross-shareholding between corporations decreased only slightly, ownership of corporate shares by financial institutions, and banks in particular, dropped significantly. It is important to note that the changes to the ownership structure of Japanese firms that occurred in the 1990s were accompanied by growing diversity of ownership. According to Table 2, the degree of dispersion of ownership rose as foreigners and individuals boosted their stake in Japanese corporations. Although the average ratio of shares held by financial institutions decreased 5% points during this decade, the standard deviation of this ratio increased. As the ownership structure of Japanese companies has become increasingly differentiated and diversified, stable shareholdings have unwound. ＝＝ Table 1/2 about here === The dramatic changes mentioned above naturally give rise to a series of questions: Why is foreign shareholding in Japanese firms on an increasing trend? Why did cross-shareholding, which had been fairly constant for more than thirty years, begin to dissolve in the mid-1990s? If cross-shareholding had been a response to a rising takeover threat, then why did this practice begin to decline just as the takeover threat grew much more serious than it had been in the 1980s? Given the increasing variance in the cross-shareholding ratio among firms, what attributes of firms determine the extent of their cross-shareholding? And lastly, what are the welfare implications of the changing ownership structure for firm performance? The task of this chapter is to answer these questions, using detailed and comprehensive data on ownership structure and individual cross-shareholding relationships developed by NLIR and Waseda University. To determine why foreigners are increasing their stakes in Japanese firms, we conduct a brief test of the home bias hypothesis, which predicts that such investors tend to purchase large and well-established stocks (Kang and Stultz 1997, Murase 2001). Using simple estimation, we present evidence that foreigners increased investments not only in large firms with high bond dependency, but also in growing firms with low default risk. Next, to shed light on the primary concern of this chapter the causes of the unwinding of 3 cross-shareholding, we approach the choice to sell from two sides, looking at the choice made by corporations to sell their bank shares, and by banks to sell their corporation shares. For the former, we estimate a Logit model in which a corporation’s decision to sell off bank shares is regressed on its need to sell, the financial health of the bank, pressure from capital markets on the corporation, the takeover threat, and the corporation’s relationship to the bank. From this estimation, we found that profitable firms with easy access to capital markets and high levels of foreign ownership prior to the banking crisis tended to wind down cross-shareholding, while low-profitability firms with difficulty accessing capital markets and low levels of foreign ownership in the early 1990s tended to maintain cross-shareholding arrangements with their banks. Our second Logit model regresses the bank’s choice to sell corporate shares on the bank’s portfolio factors, the bank’s need to sell, market pressure on the bank, growth potential, the risk level of the corporate investment, and the strength of the bank’s relationships with those corporations. Consequently, we found that a bank’s decision to sell off a stock is determined not only by portfolio factors, but also by its long-term relationships with firms. After the banking crisis, and particularly after 1999, banks reduced shareholding mainly by selling shares with higher liquidity and higher expected rates of return (i.e. shares which were easy to sell), while holding onto shares of firms with which they had long-term relationships. This was especially true when a main-bank relationship existed. Thus, the investment behavior of banks was shaped by a perverse incentive that not only undermined corporate governance but also led to the degrading of their own portfolios. Lastly, we estimate a standard model to measure the effects of firms' cross-shareholding and other shareholding patterns on corporate performance. The conjectures that are tested in this estimation support the view that stresses the costs rather than the benefits of the Japanese ownership structure. Cross-shareholding may reduce the pressure from stock markets but also may encourage managerial entrenchment and diminish rather than enhance performance by allowing managers to stay put for long periods of time. Banks that played a dual role as debt-holders and shareholders have at times used their ownership stakes to encourage client firms to take on projects with low profitability instead of preventing asset substitution. Parent firms that controlled a high percentage of the shares in their (listed) subsidiaries were prone to transfer funds from minority shareholders to controlling shareholders (parents firms) instead of encouraging better performance. 4 Institutional investors, on the other hand, played a significant positive role in monitoring firms instead of inducing managerial myopia. Indeed, this study provides evidence that high levels of institutional shareholding (either foreign or domestic) and, somewhat surprisingly, block shareholding by corporations have a positive effect on firm performance. In contrast, bank ownership has had a consistently negative effect on firm performance since the mid-1980s. These results imply the following: 1) institutional shareholders are now playing a significant monitoring role in Japanese firms by taking over some of the tasks previously performed by the (main) banks; 2) the unwinding of cross-shareholding between banks and corporations clearly produces efficiency gains; and 3) although the reasons offered up in the past to justify bank ownership of both equity and loans no longer seem to hold, the economic rationale for high levels of block holding by corporations and cross-shareholding among firms remains valid. The remainder of this chapter is organized as follows. In the next section, we briefly summarize the evolution of the ownership structure of Japanese listed firms since the postwar reforms. In the third section, we address the causes of this evolutionary change, and examine the determinants of the choice between holding and selling shares by both banks and non-financial institutions. The fourth section highlights the effect of changing ownership structure on performance. The fifth section provides a conclusion and some perspectives on future trends. 2. Approaching the Stable Shareholder Problem The puzzle Stable shareholders have usually been considered insiders friendly to share issuers. Or to put it differently, they are shareholders who make implicit contracts with issuers, promising not to sell their shares to unfriendly third parties such as green-mailers or parties who may attempt hostile takeovers, unless the issuers face a severe financial crisis that triggers suspension of dividend payments (Sheard 1994, Okabe 2002). Defining stable shareholders as corporations and financial institutions that own shares for the long term, we found that the percentage of shares held by them clearly increased in two steps ( Figure 1 ): the first increase occurred from 1950 to 1955, and the second from 1965 to 1974. The post-World War II reforms included compulsory redistribution of corporate ownership centering on 5 the dissolution of the zaibatsu. Consequently, block shareholders (zaibatsu family and holding companies) were eliminated, and individual shareholding increased. The Occupation era reforms produced the dispersed ownership structure with the low level of managerial ownership that has characterized postwar Japanese firms. The new managers who emerged to run Japanese corporations were free from effective control by large shareholders but were exposed to the myopic pressures of the stock market. Their response was to seek to stabilize the stock issued by their firms through existing networks. The adage that “shareholders don’t choose managers, managers choose friendly shareholders” aptly sums up what happened. Indeed, the fundamental principles of joint stock corporations appear to have been violated. In particular, ex-zaibatsu firms whose stock had been dispersed pressed same-line firms to purchase their stocks. The government also promoted corporate shareholding and encouraged life insurance companies to acquire stock. The movement toward stable shareholding accelerated in the wake of revisions to the Antitrust Law that deregulated shareholding (Miyajima 1995). Consequently, due to sharp increases in shareholding by financial institutions and corporations (friendly insiders), the ratio of stable shareholders increased from 23.6% in 1950 to 36.8% in 1955. After a period characterized by a relatively stable ownership structure (1956-64), ownership of shares by financial institutions and corporations increased sharply once again, with the stable shareholder ratio climbing from 47.4% in 1965 to 62.2% in 1974. During the period of capital liberalization that followed the stock price decline of 1962, corporate managers feared hostile takeovers by foreign competitors. Consequently, friendly corporations and large banks boosted their ownership stakes in firms, boosting the stable shareholder ratio. In addition, the cooperative stockholding institutions that were originally established to maintain stock prices also promoted shareholder stabilization because they sold their holdings to the affiliates or main banks of the issuers after stock prices recovered. Miyajima, Haramura, and Enami (2003) showed that the changing ratio of shares held by banks or main banks from 1964-69 was positively sensitive not only to existing relationships (measured by the level of (main) bank dependence at the beginning of the estimation), but also to corporate performance (rate of return on assets, or ROA) and growth opportunities (Tobin’s q). As delegated monitors, main banks carefully reviewed the credit risks 6 and growth opportunities of corporations that offered shares 1 . On the other hand, non-financial corporations that held onto bank shares were rational actors because the market return on bank shares was stable and usually outperformed the Tokyo Stock Exchange Stock Price Index (TOPIX) 2 . To further encourage stable shareholding, the regulatory framework under the Commercial Code was revised to allow top managers (corporate insiders) to issue new shares by allotting them to friendly third parties without approval from the general shareholders’ meeting. To use the terminology of the law and finance literature (La Porta et al. 1998), we could say that protections for minority shareholders were weakened during this phase. From the early 1970s to the early 1990s, the ownership structure of Japanese firms was remarkably stable, as many observers have emphasized 3 . Even after the mid-1980s when the Antitrust Law was revised to lower the ceiling on shareholding by a financial institution to 5% from 10%, financial institutions increased their total share in Japanese corporations. The stylized portrait of the ownership structure of Japanese firms familiar to most of us is based on this period of stable shareholding. In the 1990s, however, the stable ownership structure was undergoing quiet but important changes. We can observe from Figure 1 that these changes were of significant degree when placed in the context of the postwar evolution of Japanese corporate ownership, and in fact comparable in scale to the transformation of the late 1960s. To get a grasp of these changes, we will focus on the following questions: Why did shareholding by foreigners begin to increase and stable shareholding decrease in the 1990s? Why did the cross-shareholdings that had been extremely stable begin to unwind from 1995? If the primary motivation for shareholder stabilization was to mitigate the threat of takeover, why did stable shareholding begin to decline just as the takeover threat began to increase following the plunge in stock prices and the rise in foreign ownership of shares? In the following section, we solve this puzzle by taking a close look at the factors that characterized the ownership structure in 1 Miyajima et al. (2003) also reported that (main) bank ownership of manufacturing firms was negatively sensitive to credit risk as measured by the interest coverage ratio. But it should be noted that the positive relationship to ROA and Q is only observed for 1964-69, and not significant in the period from 1969-74. This positive correlation between bank ownership of shares and performance is consistent with Prowse (1990) and Flath (1993), which stress the role of the main bank as delegated monitor, and provide supportive results for the 1980s. 2 See Miyajima et al. (2003) for details. 3 See Prowse (1990), Frath (1993), Sheard (1994), Weinstein and Yafeh (1998), and Yafeh and Yosha (2003). 7 the 1990s. Increase in foreign shareholding Table 3 summarizes the value and volume of net selling and buying of shares by category of shareholder. We find that the rise in the fraction of shares owned by foreign investors preceded changes in the Japanese ownership structure. Foreign investors have increased their presence in the Japanese market since 1991, becoming important net buyers, while securities investment trusts turned into net sellers due to the drop in stock prices. One reason for the rise in purchases by foreign investors was the growth in pension funds in the U.S. (see Chapter 2). Ironically, falling stock prices have supported this trend since 1990. As stock prices soared during the asset bubble period, foreign institutional investors representing internationally diversified investment funds considered Japanese stocks to be overpriced. After stock prices fell, however, foreign investors could buy larger volumes of shares with a given pool of money, and began to incorporate Japanese stocks into their portfolios. ＝＝Table 3 about here＝＝ The investment behavior of foreign investors is believed to be affected by a so-called home bias, i.e. the preference for large and well-established stocks (Kang and Stultz 1997, Murase 2001). To confirm this hypothesis, we tested the following simple model: ⊿FOR t ＝F(FOR t-1 ，AVQ t ，SIZE t-1 ， BON t-1 ，DAR t-1 ，DIST t ，IND) （１） where FOR is the percentage share held by foreign institutional investors 4 , AVQ is the period average of Tobin’s q, SIZE is the logarithm of total assets, and BON is the degree of dependence on bonds (i.e. the ratio of bonds to the sum of borrowing and bonds). In addition, we included leverage, DAR,. a dummy variable for financial distress, DIST, which is 1 if net profit is negative at least one time in the estimated period, and otherwise 0, and an industry dummy, IND. The results are presented in Table 4 . Even with this simple estimation, we can observe that firm size, growth opportunity (Tobin’s 4 FOR excludes the share held by foreign companies such as Ford-Mazda, Renault-Nissan, and GM-Fuji Heavy Ind.Co. 8 q), and degree of dependence on bonds have significant positive effects on foreign ownership while leverage and financial distress have negative effects. Foreign investors increased investment in both large firms and growing firms with low default risk and high bond dependency. Moreover, comparing the two half-periods (1989-94, and 1994-99), we can see that SIZE and BON had a larger effect in the former half-period. This implies that investors targeted large and established firms. On the other hand, after 1995, the estimated effect of AVQ and DIST improved, implying that investors increasingly took corporate performance into account in the late 1990s. ＝＝ Table 4 about here ＝＝ The sale of financial institution shares by corporations The increase in foreign investors forced incumbent managers to act in the interests of general shareholders and thus to reconsider cross-shareholding arrangements. At the same time, the need to keep firms in sound financial health in order to earn high credit ratings played an important part in encouraging managers to review their securities portfolios. Moreover, with the drop in stock prices after 1995, the rate of decline of bank share prices started to exceed TOPIX’s decline, reflecting the failures of several local banks and jusen housing loan companies, and the price correction triggered by the Daiwa Bank incident in the fall of 1995 (Ito and Harada 2000). The timing of this change in bank shares prices, which had previously been synchronized with TOPIX, corresponded to the appearance of a Japan premium in the inter-bank market (Peek and Rosengren 2001). ＝＝ Figure 2 about here ＝＝ Figure 2 not only shows that the gap between the performance of bank shares and TOPIX widened since 1995 but also that the bank share price trend began to deviate from that which prevailed during the formative period of stable shareholding (1965-74), when bank shares had a higher return on investment than TOPIX (Miyajima et al. 2003). We can infer that because of both the decline in market returns of bank shares and the increased risk associated with holding onto them, firms for the first time in the postwar period had to confront the problem of whether or not to sell bank shares. According to Figure 3 , however, which summarizes the ratio of bank shares sold during the fiscal year to shares held by corporations at the beginning of the period (henceforth, the [...]... extremely important because they explain the unevenness of the unwinding of cross- shareholding As we emphasized in this chapter, the unwinding of cross- shareholding did not proceed uniformly among Japanese firms The growing differentiation in the post-banking crisis period between firms that rapidly unwound cross- shareholding and firms that continued cross- shareholding was the result of rational choices... by cross- shareholding among corporations and financial institutions will gradually change to a more market-based system but still retain some of the features of cross- shareholding arrangements, perhaps by combining cross- ownership by corporations and shareholding by institutional investors In this process, a decrease in stable shareholding is likely to increase the likelihood of hostile takeovers In. .. the inverse relation between bank ownership and performance suggests that unwinding the cross- shareholding between banks and corporations clearly allows for efficiency gains It is often pointed out that unwinding cross- shareholding may increase unnecessary pressures on management to think myopically (i.e in terms of short-term rises in the price of their stock) However, as far as the cross- shareholding... the corporate selling rate had been at least as high as that of the banks for most of this period, banks began selling off shares at a higher rate than corporations in 2000, with their selling rate reaching 40% in 2001 3 Determinants of the Unwinding of Cross- shareholding 3-1 The Data As described above, there was a general decline in cross- shareholding but the changes in the shareholding structure did... the exact ratio of shareholding by foreign institutional investors by distinguishing shares held by foreign financial and non-financial corporations 20 It also estimates the shareholding ratio of domestic institutional investors by aggregating the increasingly large number of pension and mutual funds entrusted to domestic financial institutions (mainly trust banks and insurance companies) Last, this... main-bank relationships as we saw in Chapter 1 They have fallen into a vicious circle of cross- shareholding and lax governance A key point is that firms that maintain cross- shareholding have little incentive to dissolve it Managers of the firms with low profitability and strong bank relationships (in terms of both financing and shareholding) prior to the banking crisis do not have incentives to sell shares... ownership structure begin to unwind in the late 1990s? The banking crisis was a crucial factor that directly led to the termination of many cross- shareholding arrangements between financial institutions and firms After 1995, and especially since 1997, when the banking crisis came to the surface and grew acute, it became increasingly irrational for corporations to hold bank (financial institution) shares... year into equation (1) in Section 3-2 We also introduce the dummy variable Z5 to represent corporation i’s selling bank j’s shares in the current or previous year into the bank’s shareholding choice model ((2) in Section 3-3) Of the 2,074 instances of shares sold by corporations in the entire period, there were 718 instances in which the partner bank sold off in the same year (BSL), and 304 instances in. .. described above In general, a firm’s current portfolio, liquidity constraints, and banks’ creditworthiness ratings all affect the decision to sell Additionally, other factors might also come into play The first is capital market pressure as represented by the credit ratings on corporate bonds The importance of bond financing has increased since the late 1980s such that maintaining at least a BBB rating became... public policy promoted the unwinding of cross- shareholding relationships, the need to reduce holdings became an important determinant in explaining a bank’s selling behavior On the other hand, Z2 , which tests the market’s evaluation of banks’ financial health, has a strongly positive and significant coefficient in period II11 When we divided sample firms into two 11 In period III, this variable has . been in place for almost three decades, now beginning to unwind (and what are the mechanisms of the unwinding)? What explains the increasing diversity in the patterns of cross- shareholding among. 40% in 2001. 3. Determinants of the Unwinding of Cross- shareholding 3-1. The Data As described above, there was a general decline in cross- shareholding but the changes in the shareholding. credit ratings on corporate bonds. The importance of bond financing has increased since the late 1980s such that maintaining at least a BBB rating became critical for corporate financing in the